What is Yield Farming?
Decentralized Finance, shortly termed as DeFi is an open-source protocol that provides permissionless and fast financial services. The process by which users provide liquidity to DeFi open-source protocols and get rewards is termed as DeFi Yield Farming.
In simple terms, the process of yield farming carried out on platforms that are built using DeFi protocols offers native DeFi tokens of that particular platform and this process is known as DeFi Yield Farming.
Yield farming protocols, in short, encourage liquidity providers (LPs) to lock up their crypto assets in a smart contract solution-based liquidity pool. A proportion of transaction costs, interest from lenders, or a governance token may all be obtained as rewards. These returns are calculated as a percentage yield on an annual basis (APY). The value of the released returns dips as more investors allocate funds to the associated liquidity pool.
The most common DeFi protocols run on the Ethereum network and offer governance tokens for liquidity mining. After offering liquidity to decentralized exchanges, tokens can be farmed in liquidity pools.
Important terminology in Yield Farming:
What is Liquidity?
Liquidity refers to the ability of the asset to be converted to cash. In the crypto globe, the market becomes competitive when an asset gets bought or sold more.
What are DEFI Liquidity Pools?
Liquidity Pools are smart contracts that lock up tokens or assets to facilitate trading by providing high liquidity. Liquidity Pools offer users better returns than money markets but involve certain risks.
Uniswap and Balancer are the most popular DeFi platform termed as the largest liquidity pools.
Who are DeFi Liquidity Providers?
The users who stake their assets in the liquidity pools are known as liquidity providers. Liquidity providers are also termed as market makers, as they supply what buyers and sellers want to trade.
How Does DeFi Yield Farming Works?
Yield farming is referred to as Automated Market Maker.
First, the liquidity providers deposit their assets or funds to the liquidity pool. This liquidity pool provides a marketplace where users or LPs can lend, borrow or exchange their tokens or assets. These platforms collect fees which are then paid back to the liquidity providers based on their share of the liquidity pool.
However, processes can vary with different technologies and approaches. The funds deposited are mostly stable coins pegged to USD. DAI, USDT, BUSD are the most commonly used stablecoins in DeFi yield farming.
How Are Returns Calculated in DeFi Yield Farming?
The Estimated returns in Yield farming are calculated on an annual basis. The most important metrics in the calculation of returns in yield farming are the Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
Annual Percentage Yield (APY):
The annual rate of return is charged on borrowers and paid to providers. It accounts for compounding which refers to reinvestment of profits to generate more returns.
Annual Percentage Rate (APR):
The annual rate of return imposed on borrowers and paid to the investors is termed the Annual Percentage Rate.
DeFi should find its own metrics for the calculation of returns in yield farming.
Risks in DeFi Yield Farming:
In Defi, farming involves depositing funds to a smart contract with no central authority. And if the smart contract codes are lost and found to be an error, the entire financial transaction will also be lost. This implies that the funds transferred will be lost. This makes yield farmers lose all their assets if the system is blocked.
When the DeFi smart contracts are free from vulnerabilities, the risks involved in DeFi yield farming can be reduced.
What Sparked the Rise of High-Yield Farming?
The introduction of the COMP token – the Compound Finance ecosystem’s governance token – has sparked a surge of interest in yield farming. Token holders get privileges for governance tokens.
Distributing these governance tokens algorithmically with liquidity bonuses is a common way to kickstart a decentralized blockchain. Liquidity providers are enticed to “farm” the new token by providing liquidity to the protocol.
COMP raised the popularity of this form of token distribution model. Other DeFi ventures have also devised creative ways to draw liquidity to their ecosystems.
What are the Advantages and Disadvantages of Yield Farming?
- Profit is the main advantage of yield farming. Yield farmers who implement a new project are rewarded with tokens and huge gains can be made if yield farmers sell certain tokens at the right time. Those profits can be re-invested in other DeFi projects to increase yield even more.
- Yield farmers must typically invest a substantial amount of money upfront to make any significant profits. Yield farmers face a major liquidation risk if the price drops unexpectedly, as it did with HotdogSwap, due to the highly volatile nature of cryptocurrencies, particularly DeFi tokens.
- Yield farming techniques are complicated and those who don’t completely comprehend all of the underlying protocols are at greater risk.
- Yield farmers have put their money on the project teams and the smart contract code that underpins them. Many developers and entrepreneurs start projects from the ground up or even copy the code of their predecessors. Even if the project team is trustworthy, the code is often untested and prone to bugs, making it vulnerable to attackers.
Key Challenges and Opportunities with Yield Farming:
The Ethereum blockchain is used for the majority of DeFi applications, posing some significant challenges for yield farmers. The Ethereum network is experiencing scalability issues ahead of the 2.0 update. As yield farming becomes more common, the Ethereum network becomes clogged, resulting in long confirmation times and rising transaction fees.
As a result of this scenario, some have speculated that DeFi could end up self-cannibalizing. Ethereum’s problems, on the other hand, seem to be more likely to support other networks in the long run. The Binance Smart Chain, for example, has emerged as a viable alternative for yield farmers who flocked to the network to take advantage of new DeFi DApps like BurgerSwap.
Additionally, Ethereum’s existing DeFi operators are attempting to solve the problem with their second-layer solutions for the network. As a result, assuming that Ethereum’s issues do not prove fatal to DeFi, yield farming will continue to exist.
The Future of DeFi Yield Farming:
DeFi Yield farming provides attractive returns to users at least a hundred times higher than a traditional bank on their staked crypto assets and driving the DeFi space to the next level in the crypto market.
In the future, there may be more and more DeFi based platforms inherited with automated yield farming that will tend to rock the crypto globe. This yield farming has inspired many individuals and yet to attract many in the nearer future.
Brugu’s expertise in the development of yield farming platforms:
Brugu always keeps abreast of the latest developments and trends in the DeFi and cryptocurrency space. Once you decide to get started with yield farming, reach out to our team of top specialists first.
- Our team consists of elite developers, business analysts, and marketers who offer unconditional support to your project, thereby guaranteeing its success.
- Brugu developed a reputation for its DeFi Development solutions and Services and all our services are customizable.
- We started to support DeFi based projects mostly for the aggressive growth in yield farming.